A tax on consumption, collected in instalments by businesses
VAT is Value Added Tax. It is charged when goods and services are sold, at every step of the chain from raw material to shop counter, and every registered business in that chain reclaims the VAT it was charged on its own purchases.
The result is that each business hands over tax only on the value it added, and the person at the end of the chain, who has nobody to reclaim from, carries the lot.
Follow one plank through the chain
Notice what the joiner actually parts with. They charged £60 and reclaimed £20, so £40 goes to HMRC, and £40 is a fifth of the £200 of value they added by turning £100 of timber into a £300 staircase. Same for the shop. The tax is never on turnover, it is on the margin at each step.
Which makes a registered business a collector, not a payer
This is the practical consequence and it is worth more than the theory, because it is where small businesses come unstuck.
The VAT you charge a customer is not your money and never was. It is collected on behalf of HMRC and it lands in the same bank account as everything else, which is exactly the problem. A quarter of collected VAT sitting in a current account looks like a business doing nicely, right up to the day the return is due.
A great many otherwise healthy businesses have been sunk by spending it, and the fix is dull and reliable: move it out of the trading account as it arrives, and read the balance without it.
The other side: an unregistered business bears it
Because reclaim is the mechanism, a business too small to be registered is in an odd position. It charges no VAT, which makes it cheaper for consumers, and it also cannot reclaim the VAT on anything it buys, so the tax on its materials is a real cost rather than something passing through.
That is why registration is not simply a burden and why voluntary registration exists. Somebody selling to other businesses, with substantial VAT-bearing costs, is often better off registered even below the threshold. Somebody selling to the public generally is not.
GST is the same idea. American sales tax is not.
GST in Australia and Canada is the VAT mechanism with a different name and different rates: multi-stage, with businesses reclaiming what they were charged.
American sales tax is a genuinely different instrument. It is single-stage, charged once at the final retail sale. A business buying for resale does not pay it in the first place, so there is nothing to reclaim and no chain to follow. It is also set by states and counties rather than nationally, so the rate depends on where the sale happened.
So there is no American VAT to convert to, and advice written for one system transfers badly to the other.
Doing the sums
The VAT calculator handles adding and removing it, including the trap that removing VAT is not the same as taking twenty per cent off, and it covers the rates and the difference between zero rated and exempt, which decides whether you can reclaim at all.
For whether you have to register, the VAT threshold tracker is the page, because the test is not an annual one and the forward look has no grace period. Outside the UK, the GST calculator and the small supplier threshold cover the Australian and Canadian equivalents.
Common questions
What does VAT stand for?
Value Added Tax, and the name describes the mechanism rather exactly. It is charged at every stage of a supply chain, but each registered business reclaims the VAT it paid on its own purchases, so what each one actually hands over is the tax on the value IT added. Add up everything every business in the chain remits and the total is the tax on the final sale price, which is what the end customer paid.
Who really pays VAT?
The final consumer, and nobody else in the chain, which surprises people running businesses that write large VAT cheques every quarter. A registered business charges VAT on what it sells and reclaims VAT on what it buys, so the tax passes through it. That is why VAT is described as neutral for business and why an unregistered business is in the odd position of bearing VAT it cannot reclaim.
If I am VAT registered, is the VAT I collect my money?
No, and treating it as though it were is the commonest way a small business ends up owing money it has not got. VAT charged to a customer is collected on behalf of HMRC and is not turnover. It arrives in the same bank account as everything else, which is exactly the problem, because a quarter of collected VAT sitting in a current account looks like a healthy balance right up until the return is due. Plenty of businesses move it out on receipt for that reason.
Is VAT the same as American sales tax?
No, and they are genuinely different instruments rather than the same idea with different names. Sales tax is single-stage: it is charged once, at the final retail sale, businesses buying for resale do not pay it, and there is nothing to reclaim. It is also set by individual states and counties rather than nationally, so the rate depends on where the sale happens. VAT is multi-stage with reclaim at every step. GST in Australia and Canada is the VAT mechanism under another name.
Do I have to charge VAT?
Only if you are registered, and registration is compulsory once your taxable turnover crosses a threshold, with voluntary registration available below it. The threshold test is not a simple annual one and it catches people out, because there is a rolling look backwards and a forward look with no grace period at all. Charging VAT while not registered is not a small paperwork error, it is charging people a tax you have no authority to collect.
Why can some businesses reclaim VAT and others cannot?
It depends on what you sell rather than on what you buy. A business making standard-rated or zero-rated sales can reclaim the VAT on its costs. A business making exempt sales generally cannot, because reclaim is tied to making taxable supplies. That is the practical reason the difference between zero rated and exempt matters so much, and it is why some sectors treat VAT as a genuine cost rather than as something passing through.